Widespread consternation is erupting in the investment arena, particularly in Fixed Income Departments which handles bonds. Everyone wants to find the perfect investment with 'decent' yields like 5% to 8% which are our birthright. To accomplish this, many investment advisors devise complex allocation strategies, e.g. derivatives, collateralized mortgage obligations, annuities and whole life insurance, to justify the amount they charge investors.

I still have trouble believing that these ‘Professional Fixed Income Strategists’ can add any value for their retail clients. Surely if they had the foresight and analytic ability they claim, they would have been able to detect Collateralized Mortgage Collapse or Libor Rate scam. Their losses on these investments will exceed $100,000,000,000 (yes, 100 Billion)… and the scam had been ongoing since 2008!

The players include Schwab, BofA, JP Morgan, Citi Bank – plus virtually all the biggest bond dealers abroad. Their strategies in this area have been a continuous train wreck! Why would we conclude that they can make these kinds of fixed income strategies work for small investors in the retail market?

Rates Reflect Default Risk

The truth is this: if Treasuries are paying 2, and high-yield bonds are paying 6%, the 4% difference is entirely attributable to the higher risk (i.e. default rate) plus the outrageous fees bond dealers charge. That means that for every $1million invested in junk bonds, some retail customer(s) will lose $40,000 – net of everyone else’s gains. There is no free lunch.

In Las Vegas, the casinos set the ‘vig’ or the odds by adjusting the rules. In the financial world, the Gnomes of Zurich set the vig, based on their knowledge of the default rate of the debt. This is why subprime borrowers pay higher rates (currently 6.5%) than you and I do (3.5%). In aggregate, the higher amounts of interest the banks collect from subprime loans are offset by the higher losses and administrative costs except for a very small premium. If the ‘vig’ is set too low (as it was during the real estate/mortgage meltdown), the banks and investors in these bonds see their values plummet once the defaults start.

When these bonds are wrapped up in bond funds, closed funds, or sold to individuals through large institutions, the additional costs wipe out the small premium. These costs include underwriting costs, reporting costs, distribution costs, transaction costs, and other ‘monthly expenses’ that are added in. Then the institutions have to sell the bonds for substantially more than they bought them for, and the yield realized by the small investor is correspondingly less.

Essentially, especially at today’s rates, retail investors focus on the 6% yield, and have no idea that the correct odds, or risk premium, should mathematically be 8% on the world market. Investors take much greater risks than they think they are, and are paid less for the risk. Since the default rate is relatively small, an investor may never see the loss attributable to the higher risk of any one investment. But there are real losses when investors must take pennies on the dollar after a bond when there is a default (such as GM, Lehman Bros., etc.). In a bond fund, this loss is further obfuscated by the expenses of the bond fund, and its market value.

Interestingly, when bonds are sliding toward default their value drops and they can be bought at a sizeable discount. Since the coupon (i.e. the periodic income payment from the bond) is fixed, the bond's yield rises. So a $10,000 bond with a 6% coupon pays the investor $600/year. If the bond issuer (e.g. Greece) starts to look riskier, the bond value could drop on the open market. So if the price drops to $6,000 the yield increases to 10%! To amateur investors, this makes the bond look like an even better deal simply because it has a very high yield.

Yields Increase as Bonds Become Riskier

In truth, the bond becomes more risky as the price drops and yield rises, and is considered less risky as the price of the bond increases and the yield drops. This is a fundamental truth about investing in bonds: there is no excess long-term profit in a bond investment. A higher rate of return is always accompanied by more risk. Unlike stocks, diversification in a bond portfolio does not provide protection -- only higher costs. Bond dealers (who are paid more than stock brokers) have more latitude in pricing bonds because all bonds (except Treasuries) are very thinly traded. This is because bonds have many different variables: convertible, preferred, subordinated, call features, etc. Therefore, very few bonds are traded each day so bond dealers usually hold inventories themselves.

So when you sell the bond, it doesn't sell for the amount shown on your statement--that is the 'asked' price if you were buying. The 'bid' price is generally not provided because the bond dealer will buy ONLY at a significant discount. The difference between the bid price and the asked price is called the 'spread.' These spreads are common in the sales of assets in inefficient markets, like diamonds. If you buy a diamond today and go back to sell it back tomorrow, you would likely get back only about 60 cents on the dollar since the spread is about 40%.

Since the dealer is taking the risk of holding the diamond, he can set his own prices. Stock brokers are called 'brokers' because legally they don't take title to the stocks: they are only facilitating the transaction. Most stock markets are huge so the broker never actually owns the stock and must buy and sell at market values.

It is folly to think that the ABC bond you bought today at 8% yield is 'better' than the XYZ bond your friend bought with a 7% percent yield. At the end of the day, those who bought the XYZ bond will, in aggregate, have the same amount of money as the ABC bond buyers. The defaults and additional costs of ABC buyers will offset the extra 1% in yield.

These numbers are not just 'made up' any more than the casino odds (or vig) are haphazard. If you buy bonds with the belief that you can beat the market you are thinking like a casino gambler. You can no more outsmart the house with your system, than you can get an edge in a casino. You are facing an overwhelming disadvantage since the other side has much more information, analytic capacity and cash.

Bonds Are Useful for Cash Flow

That’s why I insist that ‘safety trumps yield.’ The function of bonds in a portfolio is to provide cash flow which is certain. Since bond yields only vary between about 2% and 20%, the only way to make money in the bond market is to be a market timer. Like trying to beat the casino, the bond dealers who are betting against you know more than you do, have more cash and, are more informed, so you are the chump.

The stock market, by contrast, can be a great investment because the risk of diversification only impacts the volatility. For 'real people' the wise choice is to dollar-cost-average by saving a certain amount every month over a lifetime into a low-cost diversified index fund. Cash and bonds are held to provide long term cash flow so stock investments don't have to be liquidated.

The more complex an investment is, the less suitable it is for individuals. Complicated investment products are really designed for banks, insurance companies, and other financial institutions which can vet them properly. This is especially true for bonds. Our financial institutions offer stripped down versions of complex strategies, add on a huge profit, and sell them to people who don't really know what they are buying.

People have lost more money by chasing yield than at the point of a gun!" -- Warren Buffett.

I appreciate the discussion with our client Ward Johnson which inspired this blog. I also appreciate the professional copy editing provided by Shari Cohen.